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The Fool Portfolio, 3Com saga continues

New York, NY (March 27, 1998) -- Last Tuesday night 3Com(Nasdaq: COMS) announced third quarter earnings of $0.02, well below estimates of $0.14. Net income from ongoing operations was $7.4 million compared to $161 million a year ago ($0.45 per share). But the stock price didn't suffer much, ending the week about where it began, largely because the company successfully convinced analysts that the worst is over.

Let's look at the issues. The last 18 months have presented 3Com with a litany of problems: price competition, over-stuffed inventory channels, and a technology standards battle. But according to CEO Eric Benhamou, "We have no more hurdles to cross..." and the company expects "strong improvements in our operating performance over the next few quarters." Some agree with this assessment -- some do not.

The foremost challenge 3Com has encountered is the integration of U.S. Robotics into the company fold. When the largest merger in networking history was announced in March of 1997, U.S. Robotics was only a few days away from releasing its highly touted 56kbps modem technology known as X2. The reason why U.S. Robotics agreed to this merger at what appeared to be an opportune time can only be understood in retrospect.

U.S. Robotics was facing a significant problem with too large an inventory of modems in the reseller channel. Not only were its vendors over-stocked with standard V.34 modems, it was about to release a flood of X2 model 56 kbps modems. Exacerbating this situation was an unknown quantity -- whether consumers would be able to overcome the confusion created by X2 competing with another non-standard 56 kbps modem -- K56Flex. Apparently the consumers couldn't. Sales for both 56 kbps modem flavors were much lower than either camp anticipated. As a result, the over-stuffed sales channel has continued to be a problem for the past year.

By slowing shipments of modems to distributors and resellers and finally reducing the inventory in the sales channel, 3Com has accomplished a shorter sales-in and sales-out time frame for improved channel inventory visibility -- hopefully resulting in fewer surprises. Goals set last December for time in the channel for three product categories were achieved at the end of Q3. Modem products were reduced from 10 to 12 weeks in the channel to 8 weeks.

The long-awaited 56 kbps modem standard known as V.90, combining X2 and K56Flex technology, was finalized by the ITU (an independent standards committee) last month. Hopefully, settling the standard means that a large-scale migration to 56 kbps modems by consumers will occur. Compatibility tests with Lucent and Rockwell are complete, and 3Com is shipping V.90 standard modems now. Benhamou states that sales are starting slowly but are expected to accelerate.

There is still a wrinkle, however. Now that the industry has one unified 56 kbps modem standard, 3Com must compete on a level playing field with other modem manufacturers. This means it must compete with its rivals on a pure cost basis, and so far Lucent and Rockwell have been able to offer more affordable 56 kbps modems than 3Com.

The integration of U.S. Robotics and 3Com, two multi-billion dollar companies, has required resolving a great deal of redundancy. 3Com is in the process of cutting the number of its product distribution centers from 17 to 5, and the former U.S. Robotics manufacturing center in Chicago is being scaled back in favor of new centers overseas in Singapore and Ireland. Of interest to watchers of the former U.S. Robotics, John McCartney -- former U.S. Robotics Chief Operating Officer and a significant architect of the USR/3Com merger -- retired from the 3Com Board of Directors last week.

Still, modems are less than 50% of the 3Com product line. In the area of network interface cards (NICs), 3Com has always been the industry leader. Price competition for NICs was cruel last year with declines in the range of 40%, but Benhamou states that price competition for NICs has stabilized and adds that 3Com hopes that two recently introduced NIC products -- the Cyclone and the Hurricane -- will achieve higher gross margins and larger market share because of their superior product performance and manageability -- despite their relatively higher cost. Based on new silicon for 10/100 mbps ethernet, 3Com expects to announce new OEM agreements with computer manufacturers for these network cards.

Although Winter is traditionally a slow period for networking products and, as expected, sales in Asia are weak, Benhamou predicts that demand in the Americas and Europe is enough to make up the deficit. But 3Com still encounters double-digit price declines for network system products, modems, and remote access switches. 3Com's strategy includes new network systems products, including layer-three switching and gigabit ethernet products positioned to capture market share and add profitability in the near future. Its CoreBuilder 3500 and the CoreBuilder 9000 are set to ship in spring.

According to Benhamou, "Our inventory levels are now at the lowest they've been in the last year," and operating expenses are in control and declining. However, operating margins for the past quarter were 1.3%, and the company's target is 16 to 20% within two years.

All and all, 3Com believes its improved inventory control methods and its newly launched product cycle of NICs, network systems, and the V.90 modem signal an end to the hurdles it has faced in recent quarters. If the new product releases have enough industry appeal to generate higher gross margins and larger market share, then the future is bright. The question remains -- do these new products have enough mindshare to overcome the steep price competition from other manufacturers? Not exactly a sure thing.